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Tech Stocks Are Ripe for a Pullback, With Earnings as the Catalyst: Strategist

Cannaccord's Tony Dwyer thinks a decline could serve as an excellent buying opportunity, however.

Valuations for the tech sector are becoming stretched and one strategist is warning a pullback could be coming, with upcoming quarterly earnings as the catalyst. 

The S&P 500 Information Technology index is up 56% since the end of 2018, compared to the broader index's gain of 31%. And the IT index is up 19% in the past three months, outpacing the broader index's 10.5% gain in that span. 

Flush with cash, investors have recently been buyers of equities as economic data has improved, phase one of the U.S.-China trade deal has been completed and the Federal Reserve has made clear that it will lower interest rates if necessary. 

But Canaccord Genuity's Chief Equities Strategist Tony Dwyer is skeptical the gains can continue.

"We are reducing our market and offensive sector views from positive to neutral given the extreme overbought condition and high level of optimism toward equities, especially in the Information Technology sector," Dwyer wrote on Tuesday. 

Dwyer advises buying on a pullback, as his team is "positioning for 'a' peak but not 'the' peak," in the current bull market. Dwyer currently sees "an environment ripe for a temporary but potentially nasty drawdown that should provide an excellent entry point into equities." 

Others are getting skittish as well. "We remain vigilant as market rallies such as these often sow the seeds of their own reversals," wrote strategists in a Monday note at Unigestion Asset Management, which has $23 billion under management. 

The average stock on the S&P 500 trades at just under 19 times next year's earnings and 22 times last year's earnings, while the average forward multiple over the last 10 years, according to FactSet data, is 15 and the average trailing multiple is 19. Put that against what many view as an economy late in its expansion and valuations may look a bit frothy. 

"The market is a tinderbox looking for a spark," Dwyer said.

Related. Jim Cramer: 5 Reasons to Justify High P/E Multiples. 

One major catalyst for a downturn in tech stocks could be the earnings that are now rolling in, Dwyer wrote. Earnings for U.S. tech companies are expected to show flat growth year-over-year. Strategists at LPL financial said in a recent note that investors might overlook poor Q4 earnings and focus instead on forward guidance. But Q1 earnings for tech are expected to see just a 4.7% increase. 

IBM and Netflix report earnings on Tuesday, with Apple, Facebook, Amazon and Google all reporting before February 3. Apple  (AAPL)  trades at what some fear is a full forward multiple of roughly 24, as a rebound in iPhone sales estimates and high expectations for services and wearables have emerged. Facebook  (FB)  trades at a historically low forward multiple of 24 and has Instagram to shore up earnings growth. And Amazon  (AMZN)  trades at roughly 80 times future earnings on the back of its e-commerce and cloud dominance. 

Dwyer also noted that the relative strength index for the S&P 500 IT index has reached 82 for just the fifth time since 1990, indicting an overbought condition. The RSI uses the average gain on stocks in a given trailing period of time and compares that against historical norms to discern if stocks are overbought or oversold. The past four times the RSI has hit 82, stocks have subsequently retreated a median amount of 13.75% in the coming weeks or months, Dwyer's research showed. 

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